Saturday, January 5, 2013

Summary Of The American Taxpayer Relief Act Of 2012

Late in 2012, “fiscal cliff” was the political and economic term du jour in the United States. In short, the fiscal cliff was a combination of spending cuts and tax increases that were scheduled to automatically occur on January 1, 2013 (and in fact did occur). Many believed that such a sharp decline in the budget deficit would result in another recession. Congress and the President scrambled to reach a “deal” that combined tax relief with spending reform. On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 (the “Act”), passed merely hours prior by the Senate and House of Representatives. The Act provides for many tax law changes but very little government spending reform. Congress and the President are expected to reform government spending at a later date.

This memorandum shall serve to summarize the tax provisions of the Act that we believe are most important to our clients, both as individual taxpayers and as small business owners. Please note that many of the tax provisions in the Act are “permanent.” A provision described below as “permanent” does not mean that Congress cannot or will not amend such provision, but rather that such provision has no set expiration date. This memorandum is not intended to provide tax or business planning advice. We would not presume to give planning advice without speaking directly with you and learning all facts relevant to you or your business.

INDIVIDUAL PROVISIONS

Individual Income Tax Rates

Bush-era income tax rates are permanent for 2013 and beyond, except that taxpayers with taxable income above $400,000 ($450,000 for married taxpayers and $425,000 for heads of households) will be taxed at a 39.6% rate.

The other marginal rates for 2013 and beyond are 10, 15, 25, 28, 33, and 35 percent.

The 35% marginal rate applies to incomes between the top of the 33% rate (projected to be $398,350, or $199,175 for married taxpayers filing separately) and the $400,000/$450,000 threshold at which the 39.6% rate bracket now begins.

The 35% income bracket ranges for 2013, therefore, are:

$398,350 - $400,000 for single filers.

$398,350 - $425,000 for heads of household.

$398,350 - $450,000 for joint filers and surviving spouses.

$199,175- $225,000 for married taxpayers filing separately.

The $400,000/$450,000 threshold amounts are bottom-line taxable income, rather than adjusted gross income, as had been proposed by President Obama in the “fiscal cliff” negotiations.

As you can see, anyone with taxable income less than the $400,000/$450,000 thresholds will not see their income tax rates rise in 2013. Furthermore, those earning $200,000 ($250,000 for married taxpayers filing jointly) will remain in the 33% marginal bracket. This is important because there was a strong push to impose the top 39.6% rate on incomes above the $200,000/$250,000 threshold.

Capital Gains and Dividends

The top rate for long-term capital gains and dividends is 20% (up from 15% in 2012).

The top rate applies to the extent that a taxpayer’s income exceeds the $400,000/$450,000 thresholds.

All other taxpayers will pay a maximum rate of 15% on long-term capital gains and dividends.

Taxpayers that fall below the 15% marginal income tax bracket will pay no tax on long-term capital gains and dividends.

Short-term capital gains will continue to be taxed at individual income rates. Short-term capital gain means gain realized on the sale or disposition of capital assets held for less than one year.

Certain dividends do not qualify for the reduced tax rates and will continue to be taxed as ordinary income. Those include dividends paid by credit unions, mutual insurance companies, and farmers’ cooperatives (not an exhaustive list).

Absent any changes, the maximum rate for all capital gain would have been 20% in 2013 and beyond, expect for those below the 15% marginal tax bracket threshold. Therefore, taxpayers not in the top marginal income tax bracket will continue to enjoy a 15% tax on long-term capital gains and dividends.

Please also note that the Patient Protection and Affordable Care Act (“Obamacare”) imposes an additional 3.8% tax on Net Investment Income for individuals with taxable incomes above $200,000 ($250,000 for married taxpayers filing jointly and surviving spouses, and $125,000 for married taxpayers filing separately). This surtax applies to both short- and long-term capital gains and dividends, as well other types of investment income. Therefore, a taxpayer in the top marginal income tax bracket will pay 23.8% tax on long-term capital gains and dividends and 43.4% on short-term capital gains starting in 2013.

Alternative Minimum Tax (“AMT”)

The AMT for 2012 has been “patched,” meaning the exemption amounts have been increased and nonrefundable personal credits to the full amount of an individual’s regular tax and AMT are allowed for tax year 2012.

The new 2012 exemption amounts are as follows:

$50,600 for unmarried individuals.

$78,750 for married taxpayers filing jointly and surviving spouses.

$39,375 for married individuals filing separately.

The 2013 exemption amounts are expected to be approximately $1,000 - $2,000 higher for each above filing status.

Without the AMT “patch,” the exemption amounts would have been $33,750 for unmarried individuals, $45,000 for married taxpayers filing jointly and surviving spouses, and $22,500 for married individuals filing separately. Therefore, the “patch” greatly increases the exemption amounts and saves over 60 million taxpayers from being subject to the AMT for tax year 2012.

Although this patch is permanent, the future of the AMT remains uncertain. Some lawmakers have proposed that the AMT be abolished altogether. President Obama has proposed replacing the AMT with the so-called “Buffett Rule” which would, generally, ensure that taxpayers earning over $1 million annually would pay an effective tax rate of at least 30%. The Buffett Rule was included in the Paying a Fair Share Act, a bill rejected by the Senate in 2012. It is unclear if the Buffett Rule will be re-proposed in future legislation.

Pease Limitation

The Act revives the “Pease” limitation on itemized deductions.

The applicable threshold levels are as follows:

$300,000 for married taxpayers and surviving spouses.

$275,000 for heads of households.

$250,000 for unmarried taxpayers.

$150,000 for married taxpayers filing separately.

The “Pease” limitation is a limit on itemized deductions for higher income taxpayers. It was suspended in 2001 and again in 2010. The limitation reduces the taxpayer’s otherwise allowable itemized deductions by 3% of the amount by which the taxpayer’s adjusted gross income exceeds the applicable threshold. However, the amount of itemized deductions may not be reduced by more than 80%. Certain itemized deductions, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded. Though the limitation has been revived, the applicable threshold amounts are much higher than they were before they suspended.

Personal Exemption Phase-out

The Act revives the personal exemption phase-out rules.

The new applicable threshold levels are as follows:

$300,000 for married taxpayers and surviving spouses.

$275,000 for heads of households.

$250,000 for unmarried taxpayers.

$150,000 for married taxpayers filing separately.

Under the phase-out, the total amount of exemptions that may be claimed by a taxpayer is reduced by 2% for $2,500, or portion thereof (2% for each $1,250 for married taxpayers filing separately) by which the taxpayer’s adjusted gross income exceeds the applicable threshold level.

Federal Estate, Gift, and Generation-Skipping Transfer (“GST”) Taxes

The maximum federal estate tax rate is 40% with a $5 million annually inflation-adjusted exclusion for estates of decedents dying after December 31, 2012. The rate and exclusion are permanent.

“Portability” between spouses is permanent. Portability allows the estate of a decedent who is survived by a spouse to make a portability election to permit the surviving spouse to apply the decedent’s unused exclusion to the surviving spouse’s own transfers during life and at death.

The Act extends the deduction for state estate taxes.

There is imposed a 40% tax rate and a unified estate and gift tax exemption of $5 million for gifts made after December 31, 2012.

The Act extends numerous GST tax-related provisions that were scheduled to expire after December 31, 2012. Those provisions include the GST deemed allocation and retroactive allocation provisions, provisions allowing for a qualified severance of a trust for purposes of the GST tax, and relief from late GST allocations and elections.

The maximum estate tax rate of decedents dying after December 31, 2010 and before January 1, 2013 was 35% with a $5 million exclusion. Absent the changes enacted by the Act, the maximum rate would have been 55% with a $1 million exclusion for 2013 and beyond. The maximum gift tax rate was 35% with a $5 million exclusion for gifts made in 2011 and 2012.

Other Important Individual Tax Provisions

The Act extends through 2013 the election to claim an itemized deduction for state and local general sales taxes in lieu of state and local income taxes.

The Act permanently extends the $1,000 child tax credit. The credit was scheduled to revert to $500 per qualifying child after December 31, 2012.

The Act extends the adoption credit and the income exclusion for employer-paid or reimbursed adoption expenses up to $10,000.

The Act extends enhancements to the child and dependent care credit. The current 35% credit rate is made permanent along with the $3,000 cap on expenses for one qualifying individual and the $6,000 cap on expenses for two or more qualifying individuals.

The Act extends through 2017 the American Opportunity Tax Credit (the “AOTC”). This credit gives qualified individuals a tax credit of 100% of the first $2,000 of qualified tuition and related expenses and 25% of the next $2,000, for a maximum credit of $2,500 per eligible student. The AOTC applies to the first four years of a student’s post- secondary education.

The Act extends until December 31, 2013 the above-the-line deduction for qualified tuition and related expenses. This extension applies retroactively to 2012. This deduction and the AOTC cannot both be taken in the same year.

The Act permanently repeals the 60-month rule for the $2,500 above-the-line student loan interest deduction. The 60-month rule limited the deduction for student loan interest to 60 months. In addition, the Act permanently repeals the restriction that makes voluntary payments of interest nondeductible.

The Act reinstates the provision that treats mortgage insurance premiums as deductible interest that is qualified residence interest. This provision previously expired in 2011.

BUSINESS TAX PROVISIONS

Internal Revenue Code Section 179 Small Business Expensing

The Act extends through 2013 the enhanced Internal Revenue Code Section 179 small business expensing.

The Section 179 dollar limit for tax years 2012 and 2013 is $500,000 with a $2 million investment limit.

Without the Act, the Section 179 dollar limit for tax years beginning in 2012 would have been $125,000 with a $500,000 investment limit. In tax years after 2012, the dollar limit would have been $25,000 with a $200,000 investment limit. Unless Congress further acts, the $25,000/$200,000 limits will apply to tax years beginning in 2014.

Bonus Depreciation

The Act extends 50% bonus depreciation through 2013.

To be eligible for bonus depreciation, qualified property must be depreciable under the Modified Accelerated Cost Recovery System (MACRS) and have a recovery period of 20 years or less. The qualified property must be new and placed in service before January 1, 2014 (January 1, 2015 for certain longer production period property and certain transportation property).

Subject to the investment limitations, Section 179 expensing remains a viable alternative, especially for small business because property qualifying under Section 179 expensing can be used or new.

Work Opportunity Tax Credit

The Act extends through 2013 the Work Opportunity Tax Credit (“WOTC”), which rewards employers that hire individuals from targeted groups with a tax credit.

An individual from a “targeted group” is generally a “hard-to-employ” worker. But the Act also extends the WOTC for employers hiring qualified veterans. The credit is equal to 40% of first-year wages up to $6,000. The WOTC is part of the general business credit.

Qualified Leasehold/Retail Improvements and Restaurant Property

The Act extends through 2013 the 15-year recovery period for qualified leasehold improvements, qualified retail improvements, and qualified restaurant property.

Reduction in S Corporation Recognition Period for Built in Gains

For tax years beginning in 2012 and 2013, the recognition period for purposes of S corporations with built-in gains shall be 5 years.

When a corporation converts to an S corporation and then sells assets, any built-in gains in those assets will be taxed at the corporate tax rate (currently, 35%). Built-in gains are those gains that would exist if assets were sold upon conversion from a C corporation to an S corporation. The built-in gain amount is locked-in at the time of conversion. The Internal Revenue Code contains a rule that states that an S corporation that sells assets after conversion from a C corporation must pay the corporate tax on those built-in gains upon sale of such assets. Thus, a sale of assets with built-in gains by an S corporation could result in double taxation- the built-in gain is taxed at the 35% corporate rate and then any amount passed through to shareholders will be taxed at the shareholder’s personal rate. This rule, however, does not apply forever. Under previous law, the corporate tax liability is reduced by 10% per year that an asset remains unsold and any assets with built-in gain sold after 10 years will no longer be subject to the corporate tax. The Act replaces the 10 year recognition period with a 5 year recognition period for tax years beginning in 2012 or 2013. Therefore, if you have a company that started as a C corporation but you elected S corporation status in 2007, then by 2013 any built-in gains of the company’s assets sold in 2013 will not be taxed at corporate rate. This presents a great opportunity for S corporations that were converted from C corporations 5 or more years ago that wish to sell assets but have been hindered by the 10 year recognition period.

Please do not hesitate to call us with any questions about the American Taxpayer Relief Act of 2012 or to discuss any potential planning opportunities or concerns that may have arisen as a result of this Act.